Valuation: Management Options, Control,and Liquidity

Once you have valued the equity in a firm, it may appear to be a relatively simple exercise to estimate the value per share. But, in the case of technology firms, even this simple exercise can become complicated by the presence of management and employee options. In this chapter, we begin by considering the magnitude of this option overhang on valuation and then consider ways of incorporating the effect into the value per share.

This chapter is from the book

Once you have valued the equity in a firm, it may appear to be a relatively
simple exercise to estimate the value per share. All it seems you need to do is
divide the value of the equity by the number of shares outstanding. But, in the
case of technology firms, even this simple exercise can become com-plicated by
the presence of management and employee options. In this chapter, we begin by
considering the magnitude of this option overhang on valuation and then consider
ways of incorporating the effect into the value per share.

We also consider two other issues that may be of relevance, especially when
valuing smaller technology firms or private businesses. The first issue is the
concentration of shares in the hands of the owner/managers of these firms and
the consequences for stockholder power and control. This effect is intensified
when a firm has shares with different voting rights.

The second issue is the effect of illiquidity. When investors in a
firm's stock or equity cannot easily liquidate their positions, the lack of
liquidity can affect value. This can become an issue, not only when you are
valuing private firms, but also when valuing mall publicly traded firms with
relatively few shares traded.

Management and Employee Options

Firms use options to reward managers as well as other employees. These
options have two effects on value per share. One is created by options that have
already been granted. These options reduce the value of equity per share, since
a portion of the existing equity in the firm has to be set aside to meet these
eventual option exercises. The other is the likelihood that these firms will
continue to use options to reward employees or to compensate them. These
expected option grants reduce the portion of the expected future cash flows that
accrue to existing stockholders.

The Magnitude of the Option Overhang

The use of options in management compensation packages is not new to
technology firms. Many firms in the 1970s and 1980s initiated option-based
compensation packages to induce top managers to think like stockholders in their
decision making. What is different about technology firms? One difference is
that management contracts at these firms are much more heavily weighted toward
options than are those at other firms. The second difference is that the paucity
of cash at these firms has meant that options are granted not just to top
managers but to employees all through the organization, making the total option
grants much larger. The third difference is that some of the smaller firms have
used options to meet operating expenses and to pay for supplies.

Figure 71
summarizes the number of options outstanding as a percent of outstanding stock
at technology firms and com-pares them to options outstanding at nontechnology
firms.

As Figure 71
makes clear, the overhang is larger for younger new technology firms. In Figure
72, the number of options as a percent of outstanding stock at Amazon,
Ariba, Cisco, Motorola, and Rediff.com are reported.

Rediff.com has no options outstanding, but the other four firms have options
outstanding. Amazon, in particular, has options on 80.34 million shares,
representing more than 22% of the actual shares outstanding at the firm (351.77
million). Motorola, reflecting its status as an older and more mature firm, has
far fewer options outstanding, relative to the number of outstanding shares.

Firms that use employee options usually restrict when and whether these
options can be exercised. It is standard, for instance, that the options granted
to an employee cannot be exercised until they are vested. For vesting to occur,
the employee usually has to remain for a period that is specified in a contract.
Firms do this to keep employee turnover low, but the practice also has
implications for option valuation, as we examine later. Firms that issue options
do not face any tax consequences in the year in which they make the issue. When
the options are exercised, however, firms are allowed to treat the difference
between the stock price and the exercise price as an employee expense. This tax
deductibility also has implications for option value.

Table 7.1 summarizes the number of options outstanding at each of the firms
that we are valuing, with the average exercise price and maturity of the
options, as well as the percent of the options that are vested in each firm.

TABLE 7.1 Options Outstanding

Amazon

Ariba

Cisco

Motorola

Rediff.com

Number of options outstanding

80.34

20.675

439.00

36.98

0

Average exercise price

$27.76

$6.77

$22.52

$46.00

NA

Average maturity

9.00

9.31

6.80

6.20

NA

% vested

58%

61%

71%

75%

NA

While Amazon has far more options outstanding as a percent of
the outstanding stock, Ariba's options have a much lower exercise price, on
average. In fact, Ariba's stock price of $75 at the time of this analysis
was almost eight times the average exercise price of $6.77. The average maturity
of the options at all of these firms is also in excess of six years for Cisco
and Motorola, and in excess of nine years for Amazon and Ariba.
1 The
combination of a low exercise price and long maturity make the options issued by
these firms very valuable. Fewer of Amazon and Ariba's options are vested,
reflecting the fact that these are younger firms which have granted more of
these options recently.

Options in Existence

Given the large number of options outstanding at many technology firms, your
first task is to consider ways in which you can incorporate their effect into
value per share. The section begins by presenting the argument for why these
out-standing options matter when computing value per share and then considers
four ways in which you can incorporate their effect on value.

Why Options Affect Value per Share.Why do existing options affect
value per share? Note that not all options do. In fact, options issued and
listed by the options exchanges have no effect on the value per share of the
firms on which they are issued. The options issued by firms do have an effect on
value per share, since there is a chance that they will be exercised in the near
or far future. Given that these options offer the right to individuals to buy
stock at a fixed price, they will be exercised only if the stock price rises
above that exercise price. When they are exercised, the firm has two choices,
both of which have negative consequences for existing stockholders. The

firm can issue additional shares to cover the option exercise. But this
increases the number of shares outstanding and reduces the value per share to
existing stockholders.2 Alternatively, the firm can use cash flows from
operations to buy back shares in the open market and use these shares to meet
the option exercise. This approach reduces the cash flows available to current
equity investors in future periods and makes their equity less valuable
today.

Ways of Incorporating Existing Options into Value Four approaches are
used to incorporate the effect of options that are already out-standing into the
value per share. However, the first three approaches can lead to misleading
estimates of value.

Use fully diluted number of shares to estimate per-share value.
The simplest way to incorporate the effect of outstanding options on value per
share is to divide the value of equity by the number of shares that will be
outstanding if all options are exercised todaythe fully diluted number of
shares. While this approach has the virtue of simplicity, it will lead to too
low an estimate of value per share for two reasons:

It considers all options outstanding, not just ones that are in the
money and vested. To be fair, there are variants of this approach where the
shares outstanding are adjusted to reflect only in-the-money and vested options.

It does not incorporate the expected proceeds from exercise, which will
comprise a cash inflow to the firm.

Finally, this approach does not build in the time premium on the options
into the valuation either.

ILLUSTRATION 7.2

Fully Diluted Approach to Estimating Value per Share

To apply the fully diluted approach to estimate the per-share value, use the
equity values estimated in Chapter 6, "Estimating Firm Value," for
each firm in conjunction with the number of shares outstanding, including those
underlying the options. Table 7.2 summarizes the value per share derived from
this approach.

TABLE 7.2 Fully Diluted Approach to Estimating Value per Share

Amazon

Ariba

Cisco

Motorola

Rediff.com

Value of equity

$13,589

$17,941

$318,336

$69,957

$474

Primary shares

351.77

235.8

6890

2152

24.9

Fully diluted shares

432.11

256.475

7329

2188.98

24.9

Value per share (primary)

$38.63

$76.08

$46.20

$32.51

$19.05

Value per share (fully diluted)

$31.45

$69.95

$43.44

$31.96

$19.05

The value per share from the fully diluted approach is
significantly lower than the value per share from the primary shares
outstanding. This value, however, ignores both the proceeds from the exercise of
the options as well as the time value inherent in the options.

Estimate expected option exercises in the future and build in
expected dilution. In this approach, you forecast when in the future the
options will be exercised and build in the expected cash outflows associated
with the exercise, by assuming that the firm will buy back stock to cover the
exercise. The biggest limitation of this approach is that it requires estimates
of what the stock price will be in the future and when options will be exercised
on the stock. Given that your objective is to examine whether the price today is
correct, forecasting future prices to estimate the current value per share seems
circular. In general, this approach is neither practical nor particularly useful
for reasonable estimates of value.

Adjust for outstanding options, but add proceeds to equity. This
approach, called the Treasury Stock approach, is a variant of the fully diluted
approach. Here, the number of shares is adjusted to reflect options that are
outstanding, but the expected proceeds from the exercise (exercise price x
number of options) are added to the value of equity. The limitations of this
approach are that, like the fully diluted approach, it does not consider the
time premium on the options and there is no effective way of dealing with
vesting. Generally, this approach, by underestimating the value of options
granted, will overestimate the value of equity per share.

The biggest advantage of this approach is that it does not require a value
per share (or stock price) to incorporate the option value into per-share value.
As you will see with the last (and recommended) approach, a circularity is
created when the stock price is input into the estimation of value per
share.

ILLUSTRATION 7.3

Treasury Stock Approach

In Table 7.3, we estimate the value per share by using the treasury stock
approach for Amazon, Ariba, Cisco, Motorola, and Rediff.com.

Note that the value per share from this approach is higher than the value per
share from the fully diluted approach for each of the companies with options
outstanding. The difference is greatest for Amazon because the options have a
higher exercise price, relative to the current stock price. The estimated value
per share still ignores the time value of the options.

TABLE 7.3 Value of Equity per Share: Treasury Stock Approach

Amazon

Ariba

Cisco

Motorola

Rediff.com

Number of options outstanding

80.34

20.675

439

36.98

0

Average exercise price

$27.76

$6.77

$22.52

$46.00

$0.00

Proceeds from exercise

$2,229.84

$139.97

$9,886.28

$1,701.08

$0.00

Value of equity

$13,588.61

$17,940.64

$318,335.78

$69,956.97

$474.37

+ Proceeds from exercise

$2,229.84

$139.97

$9,886.28

$1,701.08

$0.00

Total value

$15,818.45

$18,080.61

$328,222.06

$71,658.05

$474.37

Fully diluted number of shares

432.11

256.475

7329

2188.98

24.9

Value per share

$36.61

$70.50

$44.78

$32.74

$19.05

Value options by using an option pricing model. The correct
approach to dealing with options is to estimate the value of the options today,
given today's value per share and the time premium on the option. Once this
value has been estimated, it is subtracted from the equity value and divided by
the number of shares outstanding to arrive at value per share.

Value of Equity per Share = (Value of Equity  Value of Options Outstanding)
/ Primary Number of Shares Outstanding

In valuing these options, however, you confront four measurement issues.

Vesting. Not all of the options outstanding are vested, and some
of the nonvested options might never be exercised.

Stock price. The stock price to use in valuing these options is
debatable. The value per share is an input to the process as well as the output
of the process.

Taxation. Since firms are allowed to deduct a portion of the
expense associated with option exercises, there may be a potential tax savings
when the options are exercised.

Nontraded firms. Key inputs to the option pricing model,
including the stock price and the variance, cannot be obtained for private firms
or firms on the verge of a public offering, like Rediff.com. The options must
nevertheless be valued.

These options are discussed in more detail below.

Dealing with vesting: Recall that firms granting employee options
usually require that the employee receiving the options stay with the firm for a
specified period, for the option to be vested. Consequently, when you examine
the options outstanding at a firm, you are looking at a mix of vested and
nonvested options. The nonvested options should be worth less than the vested
options, but the probability of vesting will depend on how in-the-money the
options are and the period left for an employee to vest. While there have been
attempts3 to develop option pricing models that allow for the
possibility that employees may leave a firm before vesting and forfeit the value
of their options, the likelihood of such an occurrence when a manager's
holdings are substantial should be small. Carpenter (1998) developed a simple
extension of the standard option pricing model to allow for early exercise and
forfeiture and used it to value executive options.

Arriving at a stock price to use: The answer to which stock
price to use may seem obvious. Since the stock is traded and you can obtain a
stock price, it would seem that you should be using the current stock price to
value options. However, you are valuing these options to arrive at a value per
share that you will then compare to the market price to decide whether a stock
is under- or overvalued. Thus, it seems inconsistent to use the current market
price to arrive at the value of the options and then use this option value to
estimate an entirely different value per share.

There is a solution. You can value the options by using the estimated value
per share. Doing so creates circular reasoning in your valuation. In other
words, you need the option value to estimate value per share and value per share
to estimate the option value. We would recommend that the value per share be
initially estimated by the treasury stock approach and that you then converge on
the proper value per share by iterating.4

There is another related issue. When options are exercised, they increase the
number of shares outstanding, and by doing so, they can have an effect on the
stock price. In conventional option pricing models, the exercise of the option
does not affect the stock price. These models must be adapted to allow for the
dilutive effect of option exercise. We examine how option-pricing models can be
modified to allow for dilution in Chapter 11, "Real Options in
Valuation."

Taxation: When options are exercised, the firm can deduct the
difference between the stock price at the time and the exercise price as an
employee expense, for tax purposes. This potential tax benefit reduces the drain
on value created by having options outstanding. One way in which you could
estimate the tax benefit is to multiply the difference between the stock price
today and the exercise price by the tax rate; clearly, this would make sense
only if the options are in-the-money. Although this approach does not allow for
the expected price appreciation over time, it has the benefit of simplicity. An
alternative way of estimating the tax benefit is to compute the after-tax value
of the options:

This approach is also straightforward and allows you to consider the tax
benefits from option exercise in valuation. One of the advantages of this
approach is that you can use it to consider the potential tax benefit even when
options are out-of-the-money.

Nontraded firms: A couple of key inputs to the option pricing
modelthe current price per share and the variance in stock
pricescannot be obtained if a firm is not publicly traded. There are two
choices in this case. One is to revert to the treasury stock approach to
estimate the value of the options outstanding and abandon the option pricing
models. The other choice is to stay with the option pricing models and to
estimate the value per share from the discounted cash flow model. The variance
of similar firms that are publicly traded can be used to estimate the value of
the options.

ILLUSTRATION 7.4

Option Value Approach

In Table 7.4, we begin by estimating the value of the options outstanding,
using a modified option pricing model that allows for dilution.5 To
estimate the value of the options, we first estimate the standard deviation in
stock prices6 over the previous two years. Weekly returns are used to
make the estimate, and the estimate is annualized.7 All options,
vested as well as nonvested, are valued and there is no adjustment for
nonvesting.

In estimating the after-tax value of the options at Amazon and Ariba, we have
used their prospective marginal tax rate of 35%. If the options are exercised
prior to these firms reaching their marginal tax rates, the tax benefit is lower
since the expenses are carried forward and offset against income in future
periods.

You can now calculate the value per share by subtracting the value of the
options outstanding from the value of equity and dividing by the primary number
of shares outstanding, as in Table 7.5.

The inconsistency referred to earlier is clear when you compare the value per
share estimated in Table 7.5 to the price per share used in Table 7.4 to
estimate the value of the options. For instance, Amazon's value per share
is $32.33, whereas the price per share used in the option valuation is $49. If
you choose to iterate, you would revalue the options by using the estimated
value of $32.33, which would lower the value of the options and increase the
value per share, leading to a second iteration and a third one, and so on. The
values converge to yield a consistent estimate. The consistent estimates of
value are provided in Table 7.6.

For Motorola and Ariba, the difference in value from iterating is negligible,
since the value per share that we estimated for the firms is close to the
current stock price. For Cisco, the value of the options drops by almost 40%,
but the overall effect on value is muted because the number of options
outstanding as a percent of outstanding stock is small. The difference in values
is greatest at Amazon, for two reasons. First, the value per share was
significantly lower than the current price at the time of the valuation. Second,
Amazon had the highest value for options outstanding as a percent of stock
outstanding.

TABLE 7.4 Estimated Value of Options Outstanding

Option Pricing Model

Amazon

Ariba

Cisco

Motorola

Rediff.com

Number of options outstanding

80.34

20.675

439

36.98

0

Average exercise price

$27.76

$6.77

$22.52

$46.00

$0.00

Estimated standard deviation (volatility)

85%

80%

40%

34%

80%

Stock price at time of analysis

$49.00

$75.63

$64.88

$34.25

$10.00

Value per option

$42.44

$72.92

$50.13

$11.75

$8.68

Value of options outstanding

$3,409.67

$1,508.00

$22,008.00

$435.00

$0.00

Tax rate

35.00%

35.00%

35.00%

35.00%

38.50%

After-tax value of options outstanding

$2,216

$980.00

$14,305.00

$283.00

$0.00

TABLE 7.5 Value of Equity per Share

Amazon

Ariba

Cisco

Motorola

Rediff.com

Value of equity

$13,588.61

$17,940.64

$318,335.78

$69,956.97

$474.37

 Value of options outstanding

$2,216.00

$980.00

$14,305.00

$283.00

$0.00

Value of equity in shares outstanding

$11,372.32

$16,960.71

$304,030.58

$69,674.46

$474.37

Primary shares outstanding

351.77

235.8

6890

2152

24.9

Value per share

$32.33

$71.93

$44.13

$32.38

$19.05

TABLE 7.6 Consistent Estimates of Value per Share

Amazon

Ariba

Cisco

Motorola

Rediff.com

Value of options (with current stock price)

$2,216.00

$980.00

$14,305.00

$282.51

$0.00

Value per share

$32.33

$71.93

$44.13

$32.38

$19.05

Value of options (with iterated value)

$1,500.00

$933.00

$8,861.00

$282.51

$0.00

Value per share

$34.37

$72.13

$44.92

$32.38

$19.05

Future Option Grants

While incorporating options that are already outstanding is fairly
straightforward, incorporating the effects of future option grants is much more
complicated. In this section, we examine the argument for why these option
issues affect value and discuss how to incorporate these effects into value.

Why Future Options Issues Affect Value. Just as outstanding options
represent potential dilution or cash outflows to existing equity investors,
expected option grants in the future will affect value per share by increasing
the number of shares outstanding in future periods. The simplest way of thinking
about this expected dilution is to consider the terminal value in the discounted
cash flow model. As constructed in the last chapter, the terminal value is
discounted to the present and divided by the shares outstanding today to arrive
at the value per share. However, expected option issues in the future will
increase the number of shares outstanding in the terminal year and there-fore
reduce the portion of the terminal value that belongs to existing equity
investors.

Ways of Incorporating Effect into Value per Share It is much more
difficult to incorporate the effect of expected option issues into value than
existing options outstanding. The reason is that you have to forecast not only
how many options will be issued by a firm in future periods but also what the
terms of these options will be. While this forecasting may be possible for a
couple of periods with proprietary information (the firm lets you know how much
it plans to issue and at what terms), it will become more difficult in
circumstances beyond that point. Below, we consider a way in which to obtain an
estimate of the option value and look at two ways of dealing with this estimate,
once obtained.

Estimate Option Value as an Operating or Capital Expense You can
estimate the value of options that will be granted in future periods as a
percentage of revenues or operating income. By doing so, you avoid the need to
estimate the number and terms of future option issues. Estimation will also
become easier because you can draw on the firm's own history (by looking at
the value of option grants in previous years as a proportion of revenues) and
the experiences of more mature firms in the sector. Generally, as firms become
larger, the value of options granted as a percent of revenues should become
smaller.

Having estimated the value of expected future option issues, you are left
with another choice. You can consider this value each period as an operating
expense and compute the operating income after the expense. You are assuming,
then, that option issues form part of annual compensation. Alternatively, you
can treat this value as a capital expense and amortize it over multiple periods.
While the cash flow in each period is unaffected by this distinction, it has
consequences for the return on capital and reinvestment rates that you mea-sure
for a firm.

It is important that you do not double-count future option issues. The
current operating expenses of the firm already include the expenses associated
with option exercises in the current period. The operating margins and returns
on capital that you might derive by looking at industry averages reflect the
effects of option exercise in the current period for the firms in the industry.
If the effect on operating income of option exercise in the current period is
less than the expected value of new option issues, you have to allow for an
additional expense associated with option issues. Conversely, if a
disproportionately large number of options were exercised in the last period,
you have to reduce the operating expenses to allow for the fact that the
expected effect of option issues in future periods will be smaller.

ILLUSTRATION 7.5

Valuing with Expected Option Issues

In all of the valuations you have seen so far, the current operating income
and the industry averages were key inputs. The current operating income was used
to compute the current return on capital, margin, and reinvestment rate for the
firm. The industry average margins or returns on capital were used to estimate
the stable growth inputs.

The current operating income reflects the effects of options exercised over
the last period but not the effect of new options issued. To the extent that the
latter is greater (or lower) than the former, the operating income, margins, and
returns on capital have been overstated (or understated). To illustrate the
adjustment, we consider the number of options issued and the number exercised at
Amazon and Cisco during the last year, summarized in Table 7.7, and the exercise
prices of each.

TABLE 7.7 Options Issued and Exercised: Amazon and Cisco

Amazon

Cisco

Number

Exercise Price

Value

Number

Exercise Price

Value

Options granted

31.739

$63.60

$1,273

107

$49.58

$4,589

Options canceled

11.281

$3.86



10

$24.66

$0

Options exercised

16.125

$19.70

$472

93

$6.85

$5,396

Effect on operating income

$809

+$807

The values of the option grants are estimated with the option
pricing model,8 whereas the value of the options exercised is the
exercise valuethe difference between the stock price and the exercise
price. For Amazon, the value of the options granted was significantly higher
than the value of the exercised options. Consequently, its operating loss would
have been even greater (by $809 million) than was estimated in Chapter 4 if the
difference between the exercise value and the new options granted is considered
an additional employee expense. For Cisco, on the other hand, the value of the
options exercised exceeded the value of the options granted. The difference
between the two (of $807 million) should be added to operating income to arrive
at the corrected operating income. Similar adjustments can be made to the
operating income at Ariba and Motorola; Ariba's operating income would have
been $246 million lower with the adjustment, and Motorola's would have
increased by $14 million.

The industry-average returns on capital and margins are more difficult to
adjust. You would have to make the adjustment described above to every firm in
the industry and compute returns on capital and margins after the adjustment.
For simplicity, the value of options exercised is assumed to be equal to the
value of options issued in the current period for the industry.

Table 7.8 reports on the adjustment to current operating income and the
final values per share that emerge as a result of this adjustment.

TABLE 7.8 Values per Share with Option Adjustment to Current
Operating Income

Amazon

Ariba

Cisco

Motorola

Unadjusted operating income

$(276.00)

$(163.70)

$3,455.00

$3,216.00

Value per share (no option adjustment)

$32.33

$71.93

$44.13

$32.38

Adjusted operating income

$(1,076.29)

$(409.00)

$4,262.00

$3,230.00

Value (option grant adjustment)

$26.62

$58.80

$53.04

$32.48

The effect of the adjustment is trivial at Motorola. The value
per share is lower than the original estimates at Amazon and Ariba, reflecting
the drain on value per share that options will continue to be in future years.
The value per share is higher at Cisco because of the increase in operating
income created by the adjustment.

Estimate Expected Stock Price Dilution from Option Issues. The other
way of dealing with expected option grants in the future is to build in the
expected dilution that will result from these option issues. To do so, you have
to make a simplifying assumption. For instance, you could assume that options
issued will represent a fixed percent of the outstanding stock each period and
base this estimate on the firm's history or on the experience of more
mature firms in the sector. Generally, this approach is more complicated than
the first one and does not lead to a more precise estimate of value. Clearly, it
would be inappropriate to do both: show option issues as an expense and allow
for the dilution that will occur from the issue. That double-counts the same
cost.